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Saturday, May 5, 2012

The following simple chart from Richard Duncan shows everything you need to know about our economy with one picture. It shows that total credit in the American economy grew from $1 trillion in 1964 to over $50 trillion in 2007; a 50 fold increase.

Duncan recently published an entire book on this chart titled The New Depression, which is one of the best books I have read in years. It is a must read for anyone who wants to know how the decade will play out ahead.

It is crystal clear that the growth in our economy over the past 40 years was fueled directly by the borrowing binge seen in the chart above. Consumers, businesses, banks, and all levels of government created this mountain of debt.

In 2008, when the subprime mortgage crisis hit, consumers hit the wall in their ability to borrow. The American economy, over 70% of which is made up of consumption, began to contract at every level when this occurred.

While consumers, businesses, and banks have been deleveraging (paying down or defaulting on debt), the government has stepped in to fill the void. This is why the line at the top of the chart is not falling but moving sideways.

It is the equivalent of two massive forces colliding. The government is doing everything to hold the credit markets up while the natural forces of the credit markets (think gravity) are collapsing downward. How this battle unfolds will determine the entire landscape of how our future will be shaped.

If the government cannot keep the credit markets pushed up before the private sector can step back in and take the baton with credit growth we will face a deflationary depression similar to what was seen in the 1930's.

We are going to go back to the chart above many times as we move forward, but right now I want to focus on just one part of how credit grows in our country: the financial sector. People become very confused when the see the following chart showing the monetary base growth since the crisis hit in 2008:

You can see the growth in the Federal Reserve's balance sheet. The Fed grows its balance sheet by printing money and purchasing assets in the banking system. Their two assets of choice during their quantitative easing campaigns have been mortgage bonds and treasury bonds.

What happened to this cash the banking system received when these assets were purchased? It is being held in reserves. Banks had an unlimited ability to leverage their balance sheet from 1964 to 2007, and they were a major part of the $50 trillion in credit growth. When the crisis hit and the value of their assets (such as real estate) began to fall there were no reserves available to cover these losses. The Fed has been pumping them with cash for almost four straight years to try and fill this gaping hole. The following shows their growth in "excess reserves" which is a mirror image of the vertical Federal Reserve balance sheet growth seen above:

Banks only survived the crisis because accounting rules were changed allowing them to market their assets to myth. They became zombie banks.

Let's say hypothetical Bank of Charlotte made a $1 million loan to a retail strip buyer. The strip lost two tenants and is now valued at $600,000. The bank has a $400,000 loss on its balance sheet. The Fed calls the bank and tells them they want to buy $400,000 of their residential real estate loans. The bank hands the Fed the bonds and the Fed drops off the cash. At this point the bank is still alive because it has the reserves ($400,000 in cash) available to cover the $400,000 loss from the retail strip.

This process has been happening at the largest banks across the country only it has been in the trillions of dollars through QE1 and QE2 (see charts above).

How much more cash will it take for the banks to get back above water? It is impossible to tell. As the value of both residential and commercial real estate continue to fall it means that they are clawing in quicksand to try and get back to zero. Until that point they remain "zombie banks," meaning if the accounting rules were turned back on they would immediately be bankrupt.

The true value of Bank of America stock with real accounting rules and no government backstop is zero, and the CEO of the company would tell you that. What is it worth with mark to myth accounting and a government backstop? I have no idea. Therefore I am not a buyer of the stock nor would I try and sell it short. I'd rather play black jack.

These excess reserves will only have the ability to become capital for new loans when the banks feel comfortable in both the quality of assets (or people) they are lending to and a large enough capital buffer is in place to cover previous losses.

Until that point the financial sector, along with consumers and businesses, will not be in a position to become a net addition to the credit markets.

The historical average cap rates for apartments, before we entered the commercial real estate bubble in 2002, was 10%. Historically the other sectors of the commercial real estate market listed above averaged just higher than 10% cap rates.

The fundamentals for the office and retail market are horrendous. The current trend in the business world today is for more and more people to work from home or for companies to use virtual office space.

The retail sector faces an even greater problem. Not only do consumers continue to have less disposable money to spend, the trend continues to move more shoppers toward the internet vs. driving to a store. With gas prices rising this only amplifies this problem.

The apartment sector has strong built in fundamentals: a rising population with a declining home ownership rate. This means price declines should end around the historical 10% cap rate average and buyers today should only lose about 50% of their capital.

Retail and office buyers today will see no such good fortune. While apartment buyers today will be slaughtered in the years ahead, buyers paying ridiculous 7% cap rates for a retail strip will be completed decimated..

As optimism moves out of the debt markets and interest rates begin to rise you will see a collapse across the board in these asset classes. Significant capital has been bet with tremendous leverage that interest rates will fall forever and eventually go below zero.

The following chart shows the inflation adjusted S&P 500 index going back to 1870 (click on chart for larger view). The blue lines show secular bull markets and the red lines show secular bear markets. Secular markets follow a 15 to 20 year trend on average.

The red line running through the center of the chart shows the historical uptrend. The tiny boxes show how far the market had to fall below the trend line to form a bottom and set the stage for the next bull market.

The average low during each of the past secular bull markets was 54.4% below trend line. Secular bear market bottoms usually see price to earnings ratios (P/E) well below ten with pessimism at maximum levels.

Today we are currently 45% above the long term trend line with maximum levels of optimism. Have we "cleansed" the market and formed the bottom of the current secular bear market cycle?

Wednesday, May 2, 2012

The following video headline shows that we are closer to the bottom for the residential real estate market than the top. After the final liquidation in inventory and price declines that are coming you will begin to see headlines that read: "Why Home Prices Will Fall Forever." Then it will be time to buy.

Monday, April 30, 2012

The following graph from Bianco Research shows that we are on track to breach the debt ceiling by August of this year. After that point the treasury can once again borrow from pension funds in order to push back the reckoning by about two months. The important thing to note is that this will not get us through the November elections meaning both sides can once again use this as a tool in political warfare.

Obama, like in August of 2011, can tell senior citizens that they will not receive their social security checks because of the heartless republicans. Romney can hammer into Obama saying that his fiscal irresponsibility is what brought us here in the first place. The charade should provide another dramatic show. At the end of the day the ceiling will be raised and America will continue its march toward bankruptcy. Click for larger view:

I like to spend as much time as possible being around, listening to, or reading from people that are both successful investors and extremely intelligent minds. I find myself spending less and less time (almost none) with the television on CNBC (even muted) or reading the mainstream news articles that just regurgitate headlines.

I spend more of my time now reading books, financial reports, financial newsletters, or listening to audio interviews from established economic and financial minds that take the data and provide an analysis of both where we have come from, where we are going, and why.

I'm not a trader, and I don't think I can move fast enough to beat Goldman Sacs' high frequency trading machines, so I usually don't even check what the markets are doing until the very end of the day.

The following letter comes from hedge fund manager Hugh Hendry, one of the greatest minds in the financial industry today. His view of the world is very different than what you will hear almost anywhere else, and he has not written a letter since the fall of 2010.
April 2012 TEF Commentary

Sunday, April 29, 2012

Meet Frankie Smooth. Frankie is a 25 year old real estate agent making a name for himself in the local market. He had a good year over the last 12 months and after all his expenses (which are large to keep his profile up) he has found an extra $10,000 in cash available to invest. Frankie calls his investment advisor and tells him he wants a solid return on the money but does not want to risk it in the stock market. His advisor has just the place: a 30 year treasury bond. It currently yields 3.13% annually and is considered by almost everyone to be the safest investment on the planet.

Frankie decides to lend the federal government his $10,000, collecting $313 per year in interest, knowing he will get his $10,000 back in 2042.

How many investors, when making a purchase on 30 year bonds, think about holding the bond for 30 years (also know as holding until "maturity)? My guess is very few. They think of holding a 30 year bond for its return over the next year. After that they will decide if they want to keep the money there or move it to another location. Hold that thought for just a moment.

The following table shows the public (government) finances for the worst balance sheets in the world. This chart is different than most because it projects a net present value for items such as health care and government pensions out to 2050. You may have heard these referred to as "unfunded liabilities." You can see on the chart below that the United States is the absolute worst in the world, falling slightly behind Greece.

This chart does not measure the total size of the debt. It measures the ability of the country to pay back the debt based on debt to GDP, or the total size of the economy. As the United States has the largest economy in the world, this shows how truly staggering the debt burden has become.

Why does this matter? Who cares how the United States will handle its debt 30 years from now, right? Well, it means very little for someone holding a 6 month treasury bill, but it should be extremely important for someone who is lending the government money for 30 years.

If you hold a 30 year government bond in your portfolio (if you have a retirement fund that invests in bonds or a bond fund it is almost 100% certain that you do) then you need to be concerned about the government's ability to pay you back your money in 2042. This is the year the 30 year government bond matures and you and Frankie Smooth can receive back your $10,000.

As I discussed above, most average people and financial advisors do not think about it this way. Why? They have become bond "flippers" not investors.

Back in 2004 investors took out adjustable rate loans on home mortgages. Some warned that when the loan adjusted and they needed to refinance after their "teaser" rate period rates could be higher and they might run into trouble. No problem the investors thought, they could always just go to the bank anytime beforehand and refinance if they saw that rates began to move higher.

The psychology becomes a game of musical chairs. Investors today do not understand that if interest rates on a 30 year bond move from 3.12% (where they are today) up to 5% or 6% then they will lose close to 50% of the their money.

30 year government bonds in Greece today yield over 17%, but you can clearly see with simple math above that the United States is in worse shape fiscally than Greece.

So why would investors around the world put their investments or savings sitting right on top of a land mine?

Some believe that when the building catches on fire they will be fast enough to be the first ones out. They "know" that when the music stops they will be able to find a chair. Others don't even know that they are in danger. Their financial advisor has told them that stocks are risky and bonds are safe (bonds have been rising steadily for over 30 years). Almost no one in the industry was working during a time when bonds were in a bear market (1970's). There was a similar occurrence in real estate where prices rose steadily for about 50 years heading into 2006. You would have had to find an agent that was 80 years old to find experience with falling prices.

Some investors watching the US spending horror show have decided not to sit in the building covered in gasoline with people smoking cigarettes. One of them is China; formerly the largest buyer of US treasuries and the main source of funding for the US drug/spending addiction. This has (quietly) changed over the past few years with China month after month diverging itself of US paper.

Why has this come unnoticed? Because a new buyer has entered the auctions. The Federal Reserve purchased 62% of all US treasury debt last year becoming the largest US debt holder in the world (over taking China). This has provided a temporary cap on interest rates and allowed the government to push back any discussions on a spending slow down.

While Europe and the UK (who have just entered back into recession) continue to cut back significantly on spending it has caused their economies to slow in the short term. The United States has kept the pedal to the metal and is pushing the economy full throttle with growing deficits and larger QE programs. This has temporarily created the illusion that the United States has some how emerged from the crisis much stronger than other areas around the world. The US stock market has taken the bait and has "decoupled" from the rest of the world over the past 18 months.

GDP grew in the US grew at a 2.2% rate in the first quarter. It grew by $142 billion. How much did the debt grow? $359 billion. That means it took $2.52 in debt for every $1 in growth.

This following graph from the Wall Street Journal shows the US GDP "growth" over the past 4 years. When factoring in true inflation rates, which are supposed to subtract from total GDP, the US actually contracted in the previous quarter.

This growth has been borrowed from the future with deficit spending and a printing press. While the US stock market rises and 30 year bonds continue to be the world's "store of value," understand that the professionals know exactly what is happening; this entire recovery is a mirage. They already have one foot out the door.

Over the past four years 401k investors have been removing money from "risky" stock funds and placing them into the "safety" of bonds funds holding 30 year treasuries (bankrupt federal government) and municipal bonds (bankrupt state and local governments).

Some day soon the music is going to stop, and the average investor is going to find themselves once again with the herd scrambling for the exits as smoke fills the theater. My guess is that they are all not going to make it out in time.

"We should be careful to get out of an experience only the wisdom that is in it and stop there lest we be like the cat that sits down on a hot stove lid. She will never sit down on a hot stove lid again and but she will never sit down on a cold one either."

- Mark Twain

"It's waiting that helps you as an investor, and a lot of people just can't stand to wait."

- Charlie Munger

"Live as if you were to die tomorrow. Learn as if you were to live forever."

- Gandhi

"One of the best rules anybody can learn about investing is to do nothing, absolutely nothing, unless there is something to do. I just wait until there is money lying in the corner, and all I have to do is go over there and pick it up. I wait for a situation that is like the proverbial shooting fish in a barrel."

- Jim Rogers

"Capitalism without financial failure is not capitalism at all, but a kind of socialism for the rich."

- James Grant

"At this juncture, the impact on the broader economy and financial markets of the problems in the subprime market seems likely to be contained."

- Ben Bernanke, March 2007

"Everything that needs to be said has already been said. But since no one was listening, everything must be said again."

- Andre Gide

"When people are getting richer and richer but they're not actually producing anything, it can't end well."

- Louis CK

"In economics things take longer to happen than you think they will, and then they happen faster than you thought they could."

- Rudiger Dornbusch

"I don't write about what I know. I write to find out what I know."

- Patricia Hampl

"Chains of habit are too light to be felt until they are too heavy to be broken."

- Warren Buffett

"Everyone has a plan until they get punched in the mouth."

- Mike Tyson

"Interest on the debt grows without rain."

- Yiddish Proverb

"You can have comfort, or you can have value. You cannot have both."

- Jim Grant

"Investors should remember that excitement and expenses are their enemies. And if they insist on trying to time their participation in equities, they should try to be fearful when others are greedy and greedy only when others are fearful."

- Warren Buffett

"No very deep knowledge of economics is usually needed for grasping the immediate effects of a measure; but the task of economics is to foretell the remoter effects, and so to allow us to avoid such acts as attempt to remedy a present ill by sowing the seeds of a much greater ill for the future."

- Ludwig von Mises

"Men who can both be right and sit tight are uncommon."

- Jesse Livermore

There is no means of avoiding the final collapse of a boom brought about by credit expansion. The alternative is only whether the crisis should come sooner as the result of voluntary abandonment of further credit expansion, or later as a final and total catastrophe of the currency system involved.

-Ludwig von Mises

"Most investors think quality, as opposed to price, is the determinant of whether something's risky. But high quality assets can be risky, and low quality assets can be safe. It's just a matter of the price paid for them."

- Howard Marks

"Whenever you find yourself on the side of the majority, it is time to pause and reflect."

-Mark Twain

"None are more hopelessly enslaved than those that falsely believe they are free."

-Goethe

"The longer the markets disobey basic rules of valuation, the bigger the opportunity for good investors to reap the benefits. Value investing works precisely because markets become dysfunctional at times."

-John Coumarianos

Bull markets are born on pessimism, grow on skepticism, mature on optimism, and die on euphoria. The time of maximum pessimism is the best time to buy, and the time of maximum optimism is the best time to sell.

-Sir John Templeton

"No very deep knowledge of economics is usually needed for grasping the immediate effects of a measure; but the task of economics is to foretell the remoter effects, and so to allow us to avoid such acts as attempt to remedy a present ill by sowing the seeds of a much greater ill for the future."

- Ludwig von Mises

"People only accept change in necessity and see necessity only in crisis."

-Jean Monnet

Requiring a central bank to print money to increase government's purchasing power invariably ignites a hyperinflationary firestorm. The result through history has been toppled governments and severe threats to societal stability.

- Alan Greenspan

"It is well enough that people of the nation do not understand our banking and monetary system, for if they did, I believe there would be a revolution before tomorrow morning."

- Henry Ford

"Do you want to sell sugared water for the rest of your life? Or do you want to come with me and change the world?"

-Steve Jobs

"I'd be a bum on the street with a tin cup if the markets were always efficient."

-Warren Buffett

"The market can stay irrational longer than the investor can stay solvent."

- Keynes

"While the government struggles to save one crumbling enterprise at the expense of the crumbling of another, it accelerates the process of juggling debts, switching losses, piling loans on loans, mortgaging the future and the future's future. As things grow worse, the government protects itself not by contracting this process, but by expanding it."

-Ayn Rand, 1974

"The test of a first-rate intelligence is the ability to hold two opposing ideas in mind at the same time and still retain the ability to function."

- F. Scott Fitzgerald

"All our life, so far as it has definite form, is but a mass of habits - practical, emotional, and intellectual - systemically organized for our weal or woe, and bearing us irresistibly toward our destiny, whatever the latter may be."

-William James

"Men it has been well said, think in herds; it will be seen that they go mad in herds, while they only recover their senses slowly, and one by one."

-Charles Mackay

The greatest enemy of knowledge is not ignorance, it is the illusion of knowledge.

- Stephen Hawkings

"Give me control of a nations money supply, and I care not who makes it's laws."

- Amschel Rothchild

Illusions commend themselves to us because they save us pain and allow us to enjoy pleasure instead. We must therefore accept it without complaint when they sometimes collide with a bit of reality against which they are dashed to pieces.

- Sigmund Freud

Many of life's failures are people who did not realize how close they were to success when they gave up.